Lecture 23: The Complete AD-IA Model

Fall Semester ’13-’14 Akila Weerapana

Lecture 23: The Complete AD-IA Model

I. OVERVIEW

• In the last two lectures we built up the components of the Aggregate Demand/Inflation Adjustment model. The Aggregate Demand curve summarized the relationship between inflation rates and real GDP while the Inflation Adjustment line summarized the current level of inflation that prevails in the economy.

• The AD curve would shift out when spending by consumers of firms increased, when net exports rose, when the government pursued expansionary fiscal policy (either by increasing government purchases or by cutting taxes) or when the Federal Reserve pursued expansionary monetary policy (i.e. lower interest rates) for reasons other than a fall in inflation. The revers of these factors would shift the AD curve in.

• The IA line would stay fixed in the short run unless there was a huge economy wide shock like an oil price shock or a dramatic change in people’s expectations of inflation. Over time, the IA line would rise if Y > Y

and fall as long as Y < Y

.

II. COMBINING THE AD CURVE AND THE IA LINE

• Now that we have the two relationships, the aggregate demand curve and the inflation adjust- ment line, the next task is to combine them. Since the AD curve shows how GDP responds to different inflation rates, and the IA line shows how inflation evolves in the economy, the intersection of the two gives the current rate of inflation (π

) and the current level of real GDP (Y

) in the economy.

• Note that the intersection could appear either above or below (or even exactly at) the level of potential GDP in the economy.

• Therefore, the equilibrium at Y

is only a short run equilibrium. In the case where Y

> Y

, inflation will rise over time and the IA line will shift upwards, decreasing equilibrium output until output reaches potential output. Conversely, in the case where Y

< Y

, inflation will fall over time and the IA line will shift downwards, increasing equilibrium output until output reaches potential output. When Y

= Y

,on the other hand the IA line will not shift over time and output will remain at potential output.

• These three scenarios are shown below. In each scenario, the current short-run equilibrium

is denoted as A and the eventual long-run equilibrium is denoted as B. The dashed lines

indicate the intermediate run, i.e. how the economy moves from the short run equilibrium to

the long run equilibrium.

Case 1: Y

> Y

π

Real GDP AD

π

IA

π

IA

Y

A

Y

B

Case 2: Y

< Y

π

Real GDP AD

π

IA

π

IA

Y

A

Y

B

Case 3: Y

= Y

π

Real GDP AD

π

IA

Y

= Y

A = B

III. THE AD-IA MODEL AND SHIFTS IN THE AD CURVE

Outward shift of the AD when Y = Y

• We begin by considering an outward shift in the AD curve. This could have resulted from increased consumer or investor spending, more net exports, expansionary fiscal policy in the form of a tax cut or a government purchases increase or a decision by the Fed to pursue expansionary policy, for reasons other than a change in the current inflation rate.

• The key to determining the intermediate and long run effects is the relationship between

current output and potential output. We begin by assuming the economy is currently at

Y = Y

. After the AD has shifted out, since the short run equilibrium is above potential

output, inflation will rise. As inflation rises, the IA curve will shift up and real GDP will

fall (intuitively we are moving back along the AD curve because the Fed is raising interest

rates in response to the rising inflation). This will continue until the economy has returned

to potential output.

• The initial position is denoted by A. The short run equilibrium following the outward shift of AD is shown by B. The long run equilibrium is shown by C.

π

Real GDP AD

AD

π

IA

π

IA

Y

B

Y

= Y

A

C

Inward shift of the AD when Y = Y

• Next we consider the impact of a inward shift of the AD curve. This could have resulted from decreased consumer or investor spending, fewer net exports, contractionary fiscal policy in the form of a tax hike or a cut in government purchases increase or a decision by the Fed to pursue contractionary policy for reasons other than a change in the current inflation rate.

• An example would be the cutback in military spending following the end of the cold war in the late 1980s and early 1990s or the collapse in residential investment in the United States in 2007.

• After the AD has shifted in, since the short run equilibrium is below potential output, inflation will fall over time. As inflation falls, the IA curve will shift down and real GDP will rise (intuitively we are moving back along the AD curve because the Fed is lowering interest rates in response to the falling inflation). This will continue until the economy has returned to potential output.

• The initial position is denoted by A. The short run equilibrium following the inward shift of

AD is shown by B. The long run equilibrium is shown by C.

π

Real GDP AD

AD

π

IA

π

IA

Y

Y

= Y

C

B A

Shifts of the AD when Y 6= Y

• All the diagrams, I drew above assume that the economy started out at Y

. Relaxing that assumption does not complicate things too much. What matters is not where the initial position is, but where the economy finds itself in the short-run after the AD curve has shifted.

• For example, if the short-run equilibrium is at Y

< Y

, the inflation will fall even after an expansionary policy. This is shown in the diagram below.

• The most intuitive way to think about it is that it was not that the expansionary policy (or the increase in spending) drove inflation down. Instead, what happened was that the inflation rate would have fallen even more (to point C

), given our starting position of Y

< Y

, if the AD shift out had not happened.

π

Real GDP AD

AD

π

IA

π

IA

Y

Y

C

Y

A B

C

IV. THE AD-IA MODEL AND SHIFTS IN THE IA LINE

Upward Shift of the IA when Y = Y

• Next, we consider an upward shift in the IA line in an economy that is at Y

. This could have resulted from either an oil price shock or a dramatic change in inflation expectations resulting from something like a replacement of the current Fed chair with a chair who is more likely to tolerate higher inflation.

• After the IA has shifted up and real GDP will fall because the Fed raises interest rates. Note that the interest rate hike was a result of higher inflation so there is no shift of the AD, just a movement along. The economy moves from A to B.

• Over time, since the short run equilibrium is below potential output, inflation will fall. As inflation falls, the IA line will shift down and real GDP will rise (intuitively we are moving back along the AD curve because the Fed is lowering interest rates in response to the falling inflation). This will continue until the economy has returned to potential output back at C.

π

Real GDP AD

π

IA

π

IA

Y

B

Y

= Y

A = C

Downward Shift of the IA when Y = Y

• What would happen if there was a downward shift in the IA line in an economy that is at Y

. This could have resulted from either an sharp fall in oil prices or a dramatic decrease in inflation expectations resulting from replacement of the current Fed chair with a chair who is less likely to tolerate higher inflation.

• After the IA has shifted down, real GDP will rise because the Fed has lowered interest rates.

Note that the interest rate hike was a result of lower inflation so there is no shift of the AD, just a movement along. The economy moves from A to B.

• Over time, since the short run equilibrium is above potential output, inflation will rise. As

inflation rises, the IA line will shift up and real GDP will fall (intuitively we are moving

back along the AD curve because the Fed is raising interest rates in response to the rising

inflation). This will continue until the economy has returned to potential output back at C.

π

Real GDP AD

π

IA

π

IA

Y

B

Y

= Y

A = C

A Note About Y

• All the diagrams, I drew above assume that the changes leave the level of potential output in the economy unaffected.

• Remember that potential output can increase only if the productive capacity of the economy increased, therefore labor, technology or capital has to increase as a consequence of the eco- nomic change. Possible candidates for such a change are increased spending on research and development, establishing a system of property rights, greater investment on public infras- tructure or on job training programs that reduce the time spent between jobs etc.

• Similarly, contractionary fiscal policy could negatively affect potential output; for example the cuts in spending may have reduced infrastructure or research expenditures below previously sustained levels thus harming the long run productive capabilities of the economy.

• For now, we will assume that potential output is unaffected by most changes taking place in

the economy and discuss the few exceptions to this rule in a subsequent lecture.