## Modelling a supply shock in the ASAD

You can use the ASAD to model the effect of a supply shock. The most common and relevant one to look at would be a rise in the price of oil as this is one that affects economies around the world pretty often.

The way to think about this is to think about the supply shock affecting the ‘mark-up’ in firms’ price setting decisions. If the price of oil rises, that will push firms’ costs up outside of labour costs. The mark-up, $\mu$, is not just a ‘profit’ mark-up, but captures the costs of other inputs as well.

Remember that a negative supply shock, which pushes up the profit mark-up, will cause the AS curve to shift up.

Lets see what’s going on here:
We’ve shifted from curve AS1 to AS2 which has pushed prices up from their original level (where prices were equal to expected prices, Pe), to the new price of P2. Output has fallen from the natural level of output Yn to Y2. So we have had prices going up and output going down in the short run.

It gets worse in the medium run. Remember that the starting medium run equilibrium was where prices equal expected prices. The shift of the AS curve has implied that if the supply shock is permanent, we will go to a new medium run equilibrium where prices equal expected prices at a new natural level of output, Yn’. Obviously if the supply shock is temporary, the AS curve will just shift back, but if it is permanent then firms will always face higher costs, so at any given level of prices, they will be able to produce less. This is what the shift of the AS curve has told us.

So this supply shock has meant higher prices, lower output, and if the shock is permanent, a new lower natural level of output for the economy. Supply shocks are generally bad news.

Now at this point the policy makers have a decision to make. Do they use expansionary fiscal or monetary policy, to try and increase output, or do they just leave things alone and see what happens.

If they don’t do anything, the AS curve will just keep on shifting upwards until it settles at the point where it intersects the AD curve at the new natural level of output, Yn’.

So we end up with a new expected price level, Pe=P3, where price expectations have caught up with prices, in a new medium run equilibrium, at the new natural level of output, Yn’.

Now what happens if the policy makers try to use an expansionary fiscal or monetary policy to counter the loss of output?

In the short run, this expansionary policy managed to limit the loss of output – notice how Y2 is closer to Yn in this diagram than the one above. But the price that they pay for that is that when the economy does settle at the new natural level of output, Yn’, the price level will be even higher than it was on the one above. So whilst the expansionary policy can help limit a collapse in output in the short run, when it comes to the medium run you will pay for it with higher prices. Of course there may be other reasons which motivate using an expansionary policy, you might reason that allowing output to collapse could cause permanent scars to the economy, leave a generation unemployed that will never get back into the economy, drive foreign investment out of the country and so on, which would mean your AS curve actually carried on shifting further to the left. But the basic analysis of the model is that expansionary policy would be a bad thing in terms of prices in the medium run.

What about if the policy makers actually used a contractionary policy?

This time the collapse in output in the short term is much sharper. But the eventual rise in prices by the time you get to the medium run is not as pronounced. So if you don’t mind compounding the problem of falling output in the short run by using a contractionary policy, you can get a lower price rise by the time you get to the medium run. In practice this sort of policy would not be politically very popular, but it works as a theoretical example in the model.

When you use an upward sloping AS curve rather than a horizontal “short run” and vertical “long run” AS curve it allows you to see much better what the short and medium run effects of various policies which affect aggregate supply and demand in the economy.

The key to understanding this is the concept of the short and medium run in the context of economic fluctuations. There are two things which basically define this:

1. There will be a natural level of output which is ultimately determined by the economy’s supply potential. In the short run you can be above or below it, but in the medium run you will end up tending back there. If the supply potential of the economy increases then the natural level will increase – I guess that’s how you can describe economic growth, a gradually increasing natural level of output around which there will be short run fluctuations. Blanchard uses the term ‘long run’ to deal with issues regarding economic growth over time, the medium run is the time it takes to return from a fluctuation above or below the natural level, back to the natural level, and the short run is the time you can fluctuate around the natural level.
2. The price system will ultimately be the mechanism by which you get from the short run to the medium run, ie by which you return to the natural level. When you have output above the natural level of output as determined by the supply potential in the economy, you are going to get upward pressure on prices, that will create inflation, which will push up wage demands, firms will pass on the costs of higher wages in terms of higher prices and everything will be more expensive, so your output will start to creep back towards the natural level. This will be represented by the AS curve shifting upwards. In terms of prices, the key point is price expectations. In the medium run, expected prices will always be in line with actual prices. In the short run, expected prices can be above or below actual prices, and the price mechanism will basically move to bring expectations in line with reality.

This is actually simple to understand when you draw the ASAD model, and realise how to use it.
You have price on the vertical axis, output on the horizontal axis. You have an upward sloping AS curve and a downward sloping AD curve. The point where they intersect will tell you the equilibrium level of output and price level in the economy.

Here we are starting at a medium-run equilibrium, output is at the natural level (Yn) and prices are at the level where expected prices equal actual prices.

Now for how to use this model…

The AS curve shifts up if expected prices rise or if there is a negative supply shock (eg an increase in firms’ costs which increases the mark-up the place on prices over wage costs). It shifts down if expected prices fall or if there is a positive supply shock.

The AD curve shifts out to the right if you have a monetary or fiscal expansion or an increase in consumer confidence. It shifts in if you have a monetary or fiscal contraction or a decrease in consumer confidence.

Whenever expected prices are out of step with actual prices, the AS curve will move in the direction of actual prices – this is the adjustment mechanism which gets you back to the medium run.

We can use the ASAD to analyse the short and medium run effects of various policies:
Fiscal expansion
Fiscal contraction
Monetary expansion
Monetary contraction
Supply side shocks