The AS-AD framework is a very useful economy tool, which reduces the economy into a simple model of supply and demand. The aggregate demand curve (AD) is given by the summation of consumption (C), investments (I), government purchases (G) and net exports (X-M). On the other hand, the supply curve is a function of the expected price levels. This paper uses the AS-AD model to analyse the economy at various levels of employment, and the adjustments that accompany movement various policy actions. It begins with a depiction of an economy operating at less than full employment, showing that economies often tend towards the natural level of employment. It also explores the medium term adjustment and effects of fiscal policy on output, employment and the level of prices.
Part 1 of 4
Figure 1: Economy operating at less than natural employment
The AD curve is downward sloping as shown in figure 1 due to two reasons. Firstly, higher prices reduce the real wealth and the real GDP, and secondly, increasing price levels increase interest rate, which in turn reduces investment demand as well as real GDP. The upward sloping aggregate supply curve (AS) shows the short-run, positive relationship between the expected price levels and the economy’s real output (with the wage rates, other prices and full employment remaining constant). Yfull depicts the economy’s long-run aggregate supply curve. Yfull shows the maximum possible level of output that can be produced by the economy, determined by its production function (technology, human capital, land, and labour). Along Yfull, the level of unemployment is the natural rate and the level of output is the economy’s potential GDP. At less than full employment, the economy is operating to the left of Yfull, as shown by the intersection of AS and AD curves at point e1. P=100 and Y=3 are the equilibrium price level and real GDP respectively. Further, the difference between Yfull and the equilibrium GDP represents the recessionary gap. The recessionary gap represents low output and thus low labour demand, which in turn forces wages downwards. Lower wages mean lower price inflation, low aggregate demand and supply.
Part 2 of 4
Figure 2: Medium term equilibrium
Overtime, the economy often tends towards full employment. This means that the equilibrium that is away from Yfull may only exist temporarily since forces will nudge output towards the natural level. Consider figure 2, which shows an economy at a short-term equilibrium as in figure 1. However, at equilibrium e1, the level of real GDP is less than the level of real GDP at full employment or Yfull. With the level of output falling short of full employment output, the price level turns out to be lower than was expected in the economy (too few goods). This forces employers (wage setters) to revise the expected price level downwards. Low price expectations trigger a reduction in price levels, which causes an increase in real money balances, which in turn triggers a reduction in interest rates. Input prices (wages, rents, and other prices) will also fall. Low interests and prices bring on investment and consumption borrowing, which increase aggregate supply, and thus cause a rightward shift of the aggregate supply curve. The adjustment continues until the economy’s output is just equal ton the natural output level, at which point the price level will just be equal to the expected price level and the wage setters will stop revising the wage rates. Effectively, output will remain at the full employment level, which implies that in the medium term, the economy always tends towards full employment. This is shown in figure 2, by the rightward shift of the aggregate supply curve from AS to AS1. The economy settles at a price P=£70 and real GDP= £4 trillion.
Part 3 of 4: Fiscal Policy
Figure 3: Fiscal Policy Transmission
Suppose the government cuts taxes or increases its discretionary expenditure with the economy at the natural level of employment Yfull. Figure 3 shows a graph comprising of two panels. Panel B is essentially similar to figure 2 above. An increase in government expenditure triggers an increase in demand for investment goods, which in turn shifts the IS curve rightwards. This is shown in figure 3 by the shift from IS1 to IS2, coupled by a similar increase in aggregate demand since demand puts money in the pockets of labourers/consumers, shown by the rightward shift from AD1 to AD2. Effectively, an expansionary fiscal policy results in increased output as shown by Y1 in figure 3 and price level P2. However, this is short-lived. High prices force wage setters to revise their price expectations upwards, which shifts the AS curve upwards to AS2, establishing a new equilibrium at point C. The adjustment then stops once the natural equilibrium has been restored. In panel A, increasing prices reduces real money balances, effectively shifting the LM curve upwards from LM1 to LM2, which results in higher interest rates, i2. Effectively, an expansionary fiscal policy causes a short-term increase in output and lasting increase in interest rates and price levels. Graph three shows this with increases in interest rates from i1 to i2; increases in price levels from P1 to P3; and a temporary increase in output from Yfull to Y1, then followed a movement from Y1 back to Yfull.
In an economy operating at less than full employment, it is possible to increase output, while at once keeping interest rates and price levels relatively low. This is achieved by using two policies simultaneously, but in opposite directions e.g. by combining an expansionary monetary policy with a contractionary fiscal policy. This will increase investments borrowing through lower interest rates while fiscal policy discipline counters negative effects of the first policy on output.
Part 4 of 4
The data is extracted from the World Bank for the period between 1997 and 2003 and 2007 and 3012. The price levels are represented by the purchasing power parity while the rate of unemployment is a proxy for the level of employment. On the other hand, the interest rates point to the nature of the monetary policy. The Generalized government consumption (GGC)includes current spending on goods/services by the UK government. The correlation analysis between unemployment and the GGC is -0.76526 and -0.76526
It shows from the data that the level of unemployment is relatively lower with increases in GCC and a reductions in the level of interests.
In the short term, it is evident that the economy always tends towards the full employment or natural level of employment. This means that the equilibrium that is away from Yfull may only exist temporarily since forces will nudge output towards the natural level. Short term deviations from the natural employment trigger mechanisms that force the adjustment back to the original level. Perhaps even most importantly, this model shows that in an economy with extra capacity, expansionary fiscal and monetary policies may be used to increase the level of output. While this will lead to an increase in prices and interest rates, the use of an appropriate policy mix can help neutralize this side effect.
Chapter 23: Aggregate Supply and Aggegate Demand. (2010). Retrieved Dec 7, 2014, from http://facstaff.uww.edu/ahmady/courses/econ202/ps/sg6.pdf
Blanchard, O., Giavazzi, F., & Amighinim, A. (2013). Macroeconomics: A European Perspective, 2/E. London: Pearson.
Mankiw, N. (2011). Essentials of Economics. London: Cengage Learning.
World Bank. (2014, May 17). UK: Unemployment Data. Retrieved Sept 11, 2014, from http://data.worldbank.org/indicator/SL.UEM.TOTL.ZS